Franchise Update

The Small Business Administration (SBA) has been a key player in franchise development, providing loan guarantees for franchisee start-ups. As a condition for providing these guarantees, the SBA historically required a franchisee to qualify as a small business. This meant there could be no affiliation between the franchisor and the franchisee. But standard franchise agreements typically include many “control factors” that suggest such an affiliation. Franchisors addressed this problem by creating customized addenda to their agreements intended to show the SBA there was no affiliation between franchisor and franchisee. Still, different SBA field offices developed different criteria for what constituted affiliation, which meant that lenders and franchisors could never be certain whether their addenda would satisfy the SBA’s requirements if they had to call on the SBA to honor its guaranty commitment.

To eliminate this uncertainty, the SBA has issued a new rule, Standard Operating Procedure 50 10 5(I), that provides a streamlined process to ensure compliance with its non-affiliation requirement. Effective January 1, 2017, the SBA is no longer requiring franchisors to undergo individualized review of their franchise agreements, create customized addenda to address affiliation issues, or be listed on the Franchise Registry maintained by the franchise service company Frandata. Instead, franchisors may overcome any presumption of affiliation by offering a non-negotiable, non-changeable SBA addendum to their franchise agreements.

For the franchise community, the SBA’s new Standard Operating Procedure is a welcome change from a Byzantine compliance process in which lenders, franchisees, and franchisors had to undergo a painstaking review of the franchise disclosure document (FDD) and its many exhibits to discern whether any of the control factors in those documents rose to the level of affiliation. This review added another layer of expense to opening a franchise.

The new Standard Operating Procedure addresses four key provisions typically included in a franchise agreement that the SBA deems to show an affiliation. Each of these four provisions in the new addendum will supersede any conflicting provisions in the franchise agreement:

  • Transfers of ownership of a franchisee. If a franchisee proposes to transfer a partial interest in itself, a franchisor with an option to purchase or a right of first refusal may exercise that option or right only if the proposed transferee is not a current owner, or relative of a current owner, of the franchisee. Franchisors may not unreasonably withhold any required consent to a transfer. And if an approved transfer occurs, the transferor will not be liable for the actions of the transferee franchisee.
  • Forced sales of assets. Upon termination or default, the following restrictions apply to franchisees’ business personal assets and real estate: If a franchisor has the option to buy a franchisee’s business personal assets and the parties cannot agree on their value, then an appraiser chosen by both franchisor and franchisee will determine their value. If the franchisee owns the real estate where the franchise is operating, the franchisee will not be required to sell that real estate but may be required to lease it for the remainder of the franchise term (excluding renewals) for fair market value.
  • Real estate covenants. Franchisors may not record restrictions against the use of real estate owned by franchisees where a franchise location is operating. This includes, for example, restrictive covenants, branding covenants, and environmental use restrictions.
  • Control of franchisees’ employees. Franchisors may not directly control a franchisee’s employees, including controlling the hiring, firing, or scheduling of employees.

Some have questioned whether the new Standard Operating Procedure went far enough. The new SBA addendum addresses affiliation concerns within the franchise agreement, but it does not address affiliation concerns that could arise from the many collateral documents attached to the FDD. For example, the SBA addendum does not address potential control factors involved with required non-competition agreements for franchisees and their employees or deed restriction agreements with forced sale provisions or other restrictions or covenants. Lenders may require a review of these and other documents in the FDDs and may require additional addenda to address any affiliation concerns identified in that review.

Moreover, as the SBA’s new Standard Operating Procedure is careful to note, even with the new addendum “the applicant franchisee and the franchise system must meet all SBA eligibility requirements.” Individual SBA offices still may impose requirements such as provision of access to a franchisor’s records related to a franchisee covered by an SBA guaranty; deferral of royalties for some period of time if a franchisee is delinquent on its SBA-guaranteed loan; and provision of 30 days’ notice to the SBA of a franchisee’s default before taking action to terminate the franchise agreement to allow the SBA an opportunity to cure the default.